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How to Invest: Why Investors Need to Understand Share Classes

The announcement in April of last year that Google (GOOG) would be offering a dividend, not long after Apple's (AAPL) announced their own $2.65 a share quarterly payout (which was raised to $3.05 earlier this year), gave rise to the notion that we were entering an era where major tech companies would start eschewing tradition and offering dividends. Google's dividend, though, was a dividend in name only. The company created a new set of class C shares that didn't have voting rights to be issued to shareholders, one new share per existing share, in what the company referred to as an "effective stock split."

The move, though, thrust the question of share classes into the forefront. What exactly are share classes? What do they do? Why do they exist? And what does it mean to the average investor?

In a Word? Control

At the core of different share classes lies the question of who will wield power in controlling the company. When a company goes public or issues new shares, it's essentially giving up a degree of power. The owner of a private company can do as he likes (within the law) in guiding the company without concern for losing his job. However, the CEO of a publicly traded corporation knows that his job is contingent on the shareholders. Shareholders vote on the members of the board of directors who, in turn, hire and fire the CEO.

So, what happens when a company needs to go public or issue new shares but the owners or major shareholders don't want their influence and control to be diluted? They create a new class of shares. Different share classes usually have different voting rights, so the core shareholders can know that their hold on the company won't be challenged by new shareholders. In the case of Google, for instance, the company issued two classes of shares with its 2004 IPO, with ownership retaining the Class B shares that got 10 votes for every one vote that Class A shares get. The Class C shares don't have any voting rights at all, allowing Google to split its stock and expand its shareholder base without any current owners of Google stock losing influence.

Such division of shares can be controversial, and in some places isn't even legal, but it's not uncommon in the United States and Western Europe.

Preferred Stock vs. Common Stock

Stocks sometimes breakdown even further into preferred stock and common stock. Common stock retains voting rights while preferred stock gets to collect a certain level of cash dividend before dividends can be issued to common stock. There are even what's known as "convertible preferred stock," which are preferred shares that can be converted into a set amount of common stock at any point.

One famous example of this came recently when Berkshire Hathaway's ($BRK.A)Warren Buffett offered up a $5 billion lifeline to Goldman Sachs (GS) during the financial crisis. In return, though, he received preferred share in Goldman that paid out a hefty dividend that worked out to $15 a second. Last March, Goldman finally managed to get the shares back, buying them at $110,00 a share, or $5.5 billion, with a one-time dividend of $1.64 billion that meant the Wall Street firm's earnings took a $2.80 per share hit for Q1 2011.

Do Voting Rights Really Matter?

Whether or not any of this matters to the small-time, retail investor is hard to say. Voting rights don't necessarily mean much unless you have aspirations to take over a company. Major investors like Buffett may want to be able to influence corporate policy, but they're also buying big enough stakes to matter. Smaller investors, primarily interested in dividends and growth in share value, are most likely not going to hold much power anyway. As such, nonvoting shares would do just fine.

This doesn't mean that there aren't reasons to keep share class in mind. Voting shares are likely to spike in value in a lead-up to a hostile take-over in a way that non-voting shares probably wouldn't. There's also the consideration of company management and the role they play in a company's success. Management teams holding too firm a grip on power may end up being too complacent and could offer poor guidance and/or grow complacent. Or, worse still, they could use different share classes to make a naked power grab that benefits few others than themselves.

"The hazards of entrenching control through non-voting stock can be seen at a number of companies, perhaps none the more so than at News Corporation where — despite multiple investigations of serious misconduct in recent years — the dominant shareholders remain in place," wrote Simon C Y Wong of Wired.com. "While shareholders should support strong stewardship by Google’s founders, they should not be complicit in anointing dictators by assenting to receive non-voting stock. That, in Google-speak, would be 'evil.'"

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